Capital gains or losses on property are normally triggered only when there is a “disposition” of the property (i.e., you sell it). In other words, accrued but unrealized gains are not taxed unless and until there is a disposition.
As a result, you can own property for years with large accrued gains, and not pay any tax until you sell the property.
General deemed disposition rule
However, ultimately, the tax rules will catch up to you. In particular, the Income Tax Act provides that when you die, you are deemed to have disposed of your capital properties immediately before your death, for proceeds equal to their fair market value. As a result, your accrued capital gains will be triggered (as well as any accrued capital losses). Similar rules apply to land inventory and certain resource properties that you own at the time of your death.
The person acquiring the property as a consequence of your death acquires the property at a cost equal to that same fair market value.
John dies on July 1, 2018. He owned mutual funds with a total cost of $200,000 and fair market value of $600,000 at the time of his death. He leaves the funds to his son under his will.
John will have a deemed disposition for proceeds of $600,000, resulting in a $400,000 capital gain, and half of that, or $200,000, will be a taxable capital gain included in his income on his 2018 terminal return. John’s son will acquire the funds at a cost of $600,000 for tax purposes.
Exception for spouses etc.
An exception to the above rule applies where you leave property to your spouse (or common-law partner), or a qualifying spousal trust. In such case, there is an automatic rollover, meaning that you will have a deemed disposition of the property for proceeds equal to your cost, thus leading to no gain or loss. Your spouse will pick up a cost of the property, for tax purposes, equal to your cost.
However, the executor of your estate can elect out of the rollover on a property-by-property basis. Where this election is made, the property is subject to the regular deemed disposition at fair market value rule.
(Similar rules apply to farm or fishing property left to children or grandchildren – the subject of a future Tax Letter.)
You might wonder – why make the election out of the rollover, since the rollover results in no gain and no tax? Well, there are a few possible reasons. First, if the property has an accrued loss (fair market value less than your cost), the election can trigger the loss, which can be used in the year of your death (and more on this point below). Second, even if the property has an accrued gain, you might have unutilized losses that could fully offset the gain, so that your estate will pay no tax. Meanwhile, your spouse will pick up a higher tax cost in the property (i.e., the fair market value). Third, if the property qualifies for the capital gains exemption and you have some exemption remaining, the gain can be offset by the exemption, meaning no tax for you, but again a higher tax cost for your spouse.
As noted above, the rollover also applies if the property is left to qualifying spousal trust, rather than directly to your spouse. In general terms, a qualifying spousal trust is a trust under which your spouse is entitled to all of the trust income during her lifetime, no one else may obtain the income or capital of the trust during her lifetime, and the property vests in the trust within 36 months of your death.
Allowable capital losses when you die
As noted earlier, your allowable capital losses (ACLs) can normally offset only your taxable capital gains and not other sources of income.
However, this rule is relaxed upon your death. Basically, any ACLs in the year of death, as well as those carried forward from previous years (called “net capital losses”) can offset taxable capital gains and other sources of income – both in the year of death and in the year preceding death. The ACLs subject to this rule include any that arise because of the deemed disposition upon death as described above.
There is one caveat. The amount of an ACL that can offset other sources of income will normally be reduced to the extent that you have claimed the capital gains exemption. However, such an ACL will remain available to offset taxable capital gains, including those arising due to the deemed disposition on death.